Rates: Limited Room for Rates to Rise
The yield curve should flatten further as economic strength continues to justify Fed tightening.
The Federal Open Market Committee delivered another rate hike in September, raising the federal funds rate by 25 basis points to a target range of 2.00–2.25 percent. The probability of a September rate hike was priced in at over 90 percent based on overnight index swaps (OIS) by early August. Despite this near certainty, Treasury yields increased as additional hikes were priced in further out on the curve, with two-year yields higher by 29 basis points, and five-, 10-, and 30-year yields higher by 20 basis points over the quarter. The two-year/10-year Treasury yield curve continued its flattening trend quarter over quarter, as did the two-year/10-year swap curve, though both steepened a little in early October. We believe the flattening trade remains intact as the impetus for the Fed to keep hiking remains strong for reasons outlined by our Macroeconomic and Investment Research Group.
Treasury and Swap Curve Still in a Multi-Year Flattening Trend
The two-year/10-year Treasury yield curve continued its flattening trend quarter over quarter, as did the two-year/10-year swap curve, though both steepened a little in early October. We believe the flattening trade remains intact as the Fed will keep hiking in response to strong economic data.
Source: Bloomberg, Guggenheim Investments. Data as of 10.24.2018.
Higher yields resulted in the U.S. Treasury market delivering a negative total return of -0.6 percent, and a year-to-date total return of -1.67 percent. The U.S. Treasury 20+ Year index returned -3.0 percent, bringing the year-to-date total return to -5.9 percent. The U.S. Agency index returned 0.3 percent, resulting in a year-to-date total return of -0.6 percent. The move higher in yields was not just a U.S. phenomenon: The global Treasury index returned -1.7 percent during the quarter, bringing the year-to-date total to -2.6 percent.
The move higher in yields has provided attractive buying opportunities in high-quality, long-duration fixed-income assets. For example, we are constructive on low-coupon, long-maturity callable Agency bonds, which have seen durations extend and are trading at deep discounts because of the call option being out of the money. These look especially attractive given that we do not see much more rate upside from current levels. Our Macroeconomic and Investment Research Group forecasts that 10-year Treasury yields will peak around 3.75 percent, and that the yield curve will flatten further in 2019.
10-Year Treasury Yields Are on Track to Peak Around 3.75 Percent
10-Year Treasury Yields vs “Terminal Fed Funds” as Proxied by the January 2020 Fed Funds Futures Contract
Our Macroeconomic and Investment Research Group forecasts that 10-year Treasury yields will peak around 3.75 percent, and that the yield curve will flatten further in 2019.
Source: Bloomberg, Guggenheim Investments. Based on daily data from 8.1.2017–10.11.2018.
With 30-year Treasury yields trading around 3.34 percent, we see relatively less room for yields at the long end of the curve to rise. Thus, deep-discount low-coupon callable Agency bonds provide an attractive yield with relatively limited downside based on our outlook for higher rates and a flatter curve.
—Connie Fischer, Senior Managing Director; Kris Dorr, Managing Director; Tad Nygren, CFA, Managing Director
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